DIMENSIONAL FUND ADVISORS

4th Quarter 2011

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Investors around the world have historically had a greater home bias...
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The material in this publication is provided solely as background information for registered investment advisors and in...
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F O U R T H Q UA R T ER 2 011
Joseph Kolerich
Portfolio Manager a...
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Table 1
Global Investment Grade Bond Market
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Variable Maturity within and across Countries, 3–7 years
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WHAT’S NEW AT DIMENSIONAL
Zvi Bodie to Speak at Dimensional Educational Seminars
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DISCLOSURE
Performance data shown represents past performance and is no gu...
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Fixed income tradeoffs global diversification vs increased expected returns dfa 4q2011

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Fixed Income Tradeoffs

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Fixed income tradeoffs global diversification vs increased expected returns dfa 4q2011

  1. 1. DIMENSIONAL FUND ADVISORS 4th Quarter 2011 inside: Investors around the world have historically had a greater home bias in their fixed income investments than in their equity investments. But investing in global bonds has important benefits. A dynamic approach that considers the tradeoffs between increased diversification and increased expected returns is a reliable and robust way to add value in a global bond strategy. page 2 >> 9 What’s New at Dimensional 10 Appendix A SI A PACIFI C C A N A DA What are the necessary conditions for global diversification in fixed income to be a sensible approach? What are the tradeoffs investors face when seeking global diversification in their fixed income allocation? What opportunities do they have to add value in a reliable and robust way by diversifying globally? Joseph Kolerich and Jacobo Rodríguez address these questions and consider the benefits of global diversification in fixed income. U K / EU RO PE Global Diversification vs. Increased Expected Returns 2 Research Update U NI T ED S TAT E S Fixed Income Tradeoffs:
  2. 2. . The material in this publication is provided solely as background information for registered investment advisors and institutional investors and is not intended for public use. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Expressed opinions are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as a recommendation of any particular security, strategy, or investment product.
  3. 3. Two contrasting views of stock markets The casino view sees the stock market as largely a place where investors place bets on the near future prices of stocks rather than on the numbers on a roulette wheel or the spots on a pack of cards. The casino interpretation seems even more apt for futures and options exchanges where the very structure of contracts traded emphasizes the “zero-sum” nature of the market. Casinos, of course, as suppliers of artificial risks to those with a taste for them, may well have their place in society, though presumably only a small place in a world already amply supplied with naturally occurring hazards. The danger some economists see is that as socially acceptable casinos, stock markets may actually be too attractive. They may mislead the unsophisticated into believing that stock market speculation offers a better, and certainly a quicker, way to wealth than working or saving. That short-term trading of stocks (or futures or options) is a risky activity can hardly be denied. Indeed, much of the research thrust of the academic discipline of finance has been precisely to specify the probability distributions of returns from investments in different assets and over various horizons. But those distributions arise in a way fundamentally different from those of a casino. The distributions of returns on risky stock market investments are driven not by the random fall of dice or the spin of a wheel (although it is sometimes convenient in exposition to pretend that such is the case), but by the revelation or disclosure of new information about the underlying value of a security. The information needed to value securities is not, however, just a mass of computer printout stored in a vault somewhere. Rather than a single objective entity, information, as Hayek (1945) has stressed, consists of millions of subjective bits and pieces scattered over the whole set of economic actors. One key function of secondary trading in the stock market is to aggregate these separate fragments of information. The prospect of speculative profits is the “bribe,” so to speak, society offers investors to speed the incorporation of the dispersed bits of information into prices. Once the information is incorporated, of course, everyone, including the uninformed, and not just the successful speculators, benefits from having more accurate prices on which to base decisions. —Merton H. Miller and Charles W. Upton “Strategies for Capital Market Structure and Regulation.” In Grundy, Bruce D., ed., Selected Works of Merton H. Miller, Vol. II: Economics. (Chicago: University of Chicago Press, 2002): 578-79.
  4. 4. R R E E S S E E A A R R C C H H U U P P D D A A T T E E F O U R T H Q UA R T ER 2 011 Joseph Kolerich Portfolio Manager and Vice President Dimensional Fund Advisors Fixed Income Tradeoffs: Global Diversification vs. Increased Expected Returns Financial economists have identified two factors that determine the expected returns of fixed income securities: credit and term.1 The credit (default) factor is a proxy for changes in economic conditions that change the likelihood of default, while the term (maturity) factor is a proxy for unexpected changes in interest rates. Together, those factors explain much of the common variation in the cross-section of bond returns. Research has shown that: (a) changes in interest rates are largely unpredictable and (b) the market prices of fixed income securities contain reliable information about future return differences between those securities.2 More specifically, differences in credit spreads reliably indicate when credit risk is likely to be compensated with higher expected premiums. When credit spreads widen, credit risk is expected to outperform on a relative basis; when credit spreads narrow, taking credit risk is expected to deliver less attractive credit risk premiums. This allows investors to use market-based information contained in current credit spreads to design fixed income strategies that dynamically vary the exposure to credit risk. Similarly, current term spreads, or forward rates, contain reliable information about future term risk premiums. In particular, wider (narrower) term spreads predict larger (smaller) term premiums. Again, investors can use this market-based information contained in the current shape of yield curves to design fixed income strategies that dynamically vary the exposure to term risk. Because those relationships are linear, investors can combine the information in credit and term spreads to design strategies that dynamically change the exposure to credit and term risk within both corporate and government bonds. Using data from 1973 to 2010, Plecha and Rodríguez (2011) show a simulated strategy with variable credit and variable maturity had a similar standard deviation, a similar allocation to government bonds, and a small tracking error relative to a comparable benchmark. However, the variable credit/ variable maturity strategy outperformed the benchmark by 0.4% per year by incorporating market-based information 2 L. Jacobo Rodríguez Vice President, Institutional Services Dimensional Fund Advisors in the allocation decisions. That performance differential is reliably different from zero. If it is worth it for investors to globally diversify the fixed income component of their portfolios, can this market-driven approach also add value through global diversification? If so, what are the necessary conditions for that approach to work globally? Finally, what tradeoffs do investors need to make to add value through global diversification? This article considers the benefits of global diversification in fixed income and the tradeoffs investors need to make to achieve those benefits. GLOBAL INVESTMENT GRADE BOND MARKET Table 1 shows the global investment grade bond market, as measured by the Barclays Capital Aggregate Bond Index (ex securitized issues), by issuer, duration, and type of security as of July 2011. Some details to note: First, about 80% of investment grade fixed income is government-issued debt. Despite the debt problems many governments have experienced and are likely to continue to experience, this is a market dominated by government issuers. Second, in aggregate, the US represents the biggest fraction of the global bond market, about 27% of the total market. That suggests investors who concentrate their fixed income allocation in just one country, even if that country is the US, may not be very well diversified.3
  5. 5. F O U R T H Q UA R T ER 2 011 Table 1 Global Investment Grade Bond Market Type of Security Issuer United States Effective Duration (in years) 0-5 Government Corporate 11.50% 3.81% 5-10 6.56% 0.17% 5.44% 0.01% 0-5 11.35% 2.86% 7.00% 1.40% 3.47% 0.27% 0-5 1.44% 0.96% 1.12% 0.72% 10+ 1.72% 0.31% 0-5 1.48% 0.52% 5-10 0.77% 0.23% 10+ 0.77% 0.19% 0-5 0.72% 0.40% 5-10 0.40% 0.19% 10+ 0.01% 0.01% 0-5 0.99% 0.71% 5-10 Other Developed 0.85% 5-10 Australia 11.11% 10+ Canada 0-5 5-10 United Kingdom 1.96% 10+ EMU 2.93% 2.27% 5-10 Japan 4.35% 10+ 0.66% 0.38% 10+ 0.21% 0.04% 0-5 1.34% 0.00% 5-10 Supranational 0.49% 0.00% 10+ 0.00% 0-5 2.73% 0.25% 1.84% 0.21% 10+ TOTAL 0.24% 5-10 Other Countries would make global diversification in fixed income a sensible strategy? First, markets must be sufficiently competitive, transparent, and liquid to make prices fair for all investors. Second, fixed income markets across the world must not be perfectly correlated. If bond markets across the world are not perfectly correlated, global fixed income may provide enhanced diversification due to asynchronous changes in the term structure of interest rates in different countries. On the other hand, if markets are perfectly (or even highly) correlated, the benefits from international diversification in fixed income may not be sufficient to outweigh the costs of achieving that diversification. 0.58% 19.46% U P D A T E Table 2 shows that monthly changes in the term structure of interest rates are not perfectly correlated across countries. Using the Citigroup World Government Bond Indices 1-3 years (hedged), these correlations are computed by looking at monthly changes in short-term yields across countries (or, more appropriately, currencies). Because we use the hedged indices, the correlations reflect only changes in yields, not currency fluctuations. The bottom half of the matrix shows the correlations for the entire sample period, 1985 to 2010, while the upper half shows the correlations from 1999, when the euro was introduced, to 2010. Table 2 Correlations among Changes in Short-Term Yields of Different Countries 1985–2010 Australia Canada Australia Canada Switzerland Germany/ EMU UK Japan US 0.57 Switzerland Germany/ EMU UK Japan US 0.53 0.65 0.65 0.09 0.59 0.53 0.30 0.63 0.63 0.10 0.75 0.72 0.57 0.20 0.59 0.70 0.17 0.68 0.11 0.66 0.15 0.17 0.31 0.34 0.54 0.26 0.34 0.35 0.53 0.13 0.21 0.21 0.36 0.31 0.29 0.63 0.31 0.46 0.36 0.13 0.25 0.06% 80.54% R E S E A R C H Source: Barclays Capital Global Aggregate Bond Index (ex securitized issues), as of July 2011. Some investors may have sensible reasons for limiting their fixed income exposure to just one country (e.g., for tax considerations), but, because no single issuer represents more than 30% of the investment universe, it makes sense for most investors to look at fixed income investments outside their home country. What are the necessary conditions that 1985–2010 1999–2010 Source: Citigroup World Government Bond Indices, 1-3 years (hedged). It is not just that yield curves across countries move very differently; the yield curves themselves have different shapes and nominal levels. This provides important diversification benefits, expands the variable maturity opportunity set, and, as will be shown below, creates opportunities to add value by using market-based information across countries. Using the Citigroup World Government Bond Indices 1-3 years and 3-5 years (hedged), every month we calculate the slope between the short (1-3 years) and the intermediate (3-5 years) indices for each country in the sample.4 We then 3
  6. 6. R E S E A R C H U P D A T E F O U R T H Q UA R T ER 2 011 compute the average slope for all the countries, the standard deviation, and the maximum and minimum slope for all the months in the sample (see Figure 1). Table 4 Diversification Benefits of Global Bonds 1985–2010 Figure 1 Short–Intermediate Term Slopes across Countries 1985–2010 Avg. Std. Dev. Max. (52 basis points per month for the global index versus 54 basis points per month for the US index).5 1-3 Years Index Min. US WGBI (hedged) Monthly Average Return 0.50 0.49 Monthly Std. Dev. 0.55 0.42 1.50 1.13 0.75 0.38 0 Reduction in Volatility -0.38 24.0% 1-5 Years Index -0.75 -1.13 1985 1990 1995 2000 2005 US WGBI (hedged) Monthly Average Return 0.54 0.52 Std. Dev. 0.74 0.54 2010 To get a more concise view of the variability of yield curves, Table 3 shows time series statistics for the whole sample period of 1985 to 2010 and for the post-euro sample period of 1999 to 2010. Reduction in Volatility Table 3 Time Series Averages of Cross-Sectional Statistics 1985–2010 1999–2010 Cross-Sectional Mean Slope 0.17 0.20 Cross-Sectional Std. Dev. 0.19 0.15 Maximum Monthly Slope 0.48 0.53 Minimum Monthly Slope -0.19 -0.09 Source: Citigroup World Government Bond Indices, 1-3 years and 3-5 years (hedged). As the preceding analysis shows, yield curves don’t move in lockstep. That is good news for investors who want to diversify their fixed income allocation with global bonds. Table 4 shows that investing in global bonds substantially reduces the volatility of a fixed income portfolio relative to a US-only portfolio. For instance, using the monthly returns of the Citigroup World Government Bond Index 1-3 years (hedged) from 1985 to 2010, global bonds had similar returns to US bonds (49 basis points for the global index versus 50 basis points for the US index), but the monthly volatility of the global index was 24% lower than that of the US index (42 basis points for the global index versus 55 basis points for the US index). In the intermediate segment of the yield curve, 3–5 years, we obtain a similar reduction in volatility (27%) when we move from a US index to a global one with about the same monthly average returns 4 26.9% Source: Citigroup World Government Bond Indices, 1-3 years and 1-5 years (hedged). Asynchronous changes in yield curves and very different yield curve shapes across countries create the necessary conditions to add value by investing in global bonds. In the next section, we look at how a market-driven approach can be implemented in global portfolios VARIABLE MATURITY SELECTING COUNTRIES Research has shown that changes in interest rates are largely unpredictable. That research has also shown that differences in expected returns among fixed income securities can be inferred from current market prices. That is the basis for a market-based, variable maturity approach. This approach uses information in the yield curve to shift the maturity of a portfolio so that term risk is taken when it is expected to pay off (that is, when expected term premiums are positive). That happens when yield curves are steep, when forward rates are high. The key then is to identify the steepest segments of the curve, the highest forward rates, because this is where expected returns are highest.
  7. 7. F O U R T H Q UA R T ER 2 011 We can apply this variable maturity approach in a global setting by selecting the countries with the steepest yield curves, with the highest forward rates, within a given term window rather than moving up and down the maturity spectrum within one country. Table 5 Variable Maturity Selecting Countries, 3–5 Years Table 5 shows the benefits of this dynamic approach relative to a static approach that weights each country by its market capitalization and includes all countries in the universe. The volatility of the portfolio, as measured by the standard deviation, is a proxy for the diversification benefits of investing globally. Moving from a US strategy to a static global strategy with full market coverage reduces the monthly standard deviation from 114 basis points to 75 basis points, and the average monthly return from 61 basis points to 57 basis points due to the shape of the US curve during this time period. The variable country strategy gives up some diversification (its global coverage is only 50% versus 100% for the plain strategy) and some of the benefits that come with it (the standard deviation increases from 75 basis points to 93 basis points). But it does so with the explicit intention of increasing expected returns—in this case, by 7 basis points a month during this period. This return differential between the variable country approach and the static maturity approach is reliably different from zero, as indicated by a t-statistic that is over three standard errors away from zero. Compared with the initial US-only strategy, the global strategy reduces volatility and enhances expected returns by expanding the opportunity set of bonds and yield curves. Plain 3-5 (hedged) US Avg. Monthly Return 0.64 0.57 0.61 Standard Deviation 0.93 0.75 1.14 Diff. Monthly Return 0.07 t-statistic 3.03 Compound Return (Annualized) 7.86 7.01 7.46 Avg. Hedged Yield 5.87 5.40 5.50 Avg. UnHedged Yield Let’s use a simple example to see the benefits of this approach. Assume that the term window is 3 to 5 years. To ensure sufficient diversification, our variable maturity strategy will cover 50% of the total global market capitalization by selecting those countries with the steepest yield curves; otherwise, if diversification was not a concern, we could just allocate 100% of the portfolio to the country with the steepest yield curve to have the highest expected return. The individual country cap is equal to twice the market capitalization of that country (e.g., if the UK represents 1% of the global bond market in the 3–5-year segment of the market, the maximum allocation to the UK cannot exceed 2%). Finally, the currency exposure is hedged. Global Strategy 4.53 4.63 Avg. Duration 3.48 3.49 3.44 Avg. Maturity 4.00 4.00 R E S E A R C H 4.00 U P D A T E Source: Citigroup World Government Bond Indices, 1-3 and 3-5 years (hedged). The countries in the sample are Australia, Canada, Switzerland, Belgium, Germany, Spain, France, the Netherlands, the UK, Japan, Norway, New Zealand, Sweden, and the US, as data become available. The sample period is 1985 to 2010. To check the robustness of these results, we repeat the experiment in two other segments of the yield curve, 5–7 years and 7–10 years. The results are very similar. A move from a US strategy to a global strategy leads to significant reductions in volatility without much variation in expected returns. Moving from a global strategy with all countries included to our variable maturity strategy that invests in only those countries with the steepest yield curves increases expected returns but decreases the diversification benefits. Once again, the differences in expected return between the plain strategy and the variable maturity strategy are reliably different from zero in both cases, as indicated by the large t-statistics (see Tables 6 and 7). 5
  8. 8. R E S E A R C H F O U R T H Q UA R T ER 2 011 Table 6 Variable Maturity Selecting Countries, 5–7 Years Plain 5-7 (hedged) US Avg. Monthly Return 0.73 0.64 0.67 Standard Deviation 1.21 1.02 1.53 Diff. Monthly Return 0.09 t-statistic 3.13 Compound Return (annualized) 9.00 7.89 8.15 Avg. Hedged Yield 6.15 5.69 5.93 Avg. Unhedged Yield 4.67 4.75 Avg. Duration 4.95 4.96 4.81 Avg. Maturity U P D A T E Global Strategy 6.00 6.00 6.02 Source: Citigroup World Government Bond Indices, 3-5 and 5-7 years (hedged). The countries in the sample are Australia, Canada, Switzerland, Belgium, Germany, Spain, France, the Netherlands, the UK, Japan, Norway, New Zealand, Sweden, and the US, as data become available. The sample period is 1985 to 2010. Table 7 Variable Maturity Selecting Countries, 7–10 Years Global Strategy Plain 7-10 (hedged) US Avg. Monthly Return 0.74 0.67 0.70 Standard Deviation 1.48 1.32 1.95 Diff. Monthly Return 0.07 t-statistic 2.17 Compound Return (annualized) 9.16 8.23 8.52 Avg. Hedged Yield 6.30 5.87 6.15 Avg. Unhedged Yield 4.67 4.93 Avg. Duration 6.74 6.69 6.35 Avg. Maturity 8.53 8.53 8.55 Source: Citigroup World Government Bond Indices, 5-7 and 7-10 years (hedged). The countries in the sample are Australia, Canada, Switzerland, Belgium, Germany, Spain, France, the Netherlands, the UK, Japan, Norway, New Zealand, Sweden, and the US, as data become available. The sample period is 1985 to 2010. 6 In all these cases, we first expand the universe of countries to add diversification and reduce the volatility of the portfolio, and then give up some of that diversification to increase expected returns. Thus, the tradeoff investors need to make is one between diversification and expected returns. In these examples, we give up 50% of the global market capitalization to increase expected returns by investing only in those countries with the highest expected returns, as represented by the steepest yield curves. VARIABLE MATURITY SELECTING COUNTRIES AND MATURITIES In the previous examples, we selected the countries with the steepest yield curves at a given maturity segment in each period. But there is nothing that prevents us from varying the maturity within each of the chosen countries as the term premiums in those countries vary. The goal is to constantly choose the countries with the steepest yield curves and to constantly choose the steepest segments of those curves within each country to maximize expected term premiums across and within countries. Table 8 shows summary statistics for a simulated strategy that dynamically varies the country and term exposure. For this example, the term window is 3–7 years, the market capitalization coverage is also 50%, and the individual country cap is equal to twice the market capitalization of that country. As in the previous examples, moving from a US strategy to a global strategy leads to significant reductions in volatility (the monthly standard deviation goes from 1.3% for the US strategy to 0.9% for the static global strategy) without much variation in expected returns (63 basis points per month for the US vs. 60 basis points per month for the plain global strategy). Moving from a static global strategy with all countries included to our variable maturity strategy that invests in only those countries with the steepest yield curves increases expected returns by 6 basis points per month but decreases the diversification benefits (the monthly standard deviation goes from 0.9% to 1.0%). Once again, the difference in expected return between the plain strategy and the variable maturity strategy is reliably different from zero, as indicated by a t-statistic of 2.6.6
  9. 9. F O U R T H Q UA R T ER 2 011 Table 8 Variable Maturity within and across Countries, 3–7 years Global Strategy Plain 3-7 (hedged) US Avg. Monthly Return 0.66 0.60 0.63 Std. Deviation 1.03 0.85 1.26 Diff. Monthly Return 0.06 t-statistic 2.55 coverage. In other words, as we decrease the level of market coverage, the diversification benefits of investing in global bonds also decrease. Table 9 Trading Off Diversification with Expected Returns Coverage Monthly Average Return Monthly Standard Deviation 1.0 0.60 0.85 0.9 0.62 0.88 2.85 7.60 0.8 0.63 0.89 3.23 0.7 0.64 0.92 2.79 U P D A T E 7.75 7.87 t-statistic Comp. Return (annualized) R E S E A R C H 7.34 Comp. Return (annualized) 8.15 7.34 0.6 0.64 0.97 2.38 7.95 Avg. Hedged Yield 5.96 5.51 0.5 0.66 1.03 2.55 8.15 Avg. Unhedged Yield 4.69 4.67 0.4 0.67 1.07 2.56 8.28 0.3 0.68 1.13 2.67 8.45 0.2 0.69 1.21 2.51 8.56 US 3-7 0.63 1.26 Avg. Duration 3.92 4.05 Avg. Maturity 4.62 7.69 4.77 Source: Citigroup World Government Bond Indices, 1-3, 3-5, and 5-7 years (hedged). The countries in the sample are Australia, Canada, Switzerland, Belgium, Germany, Spain, France, the Netherlands, the UK, Japan, Norway, New Zealand, Sweden, and the US, as data become available. The sample period is 1985 to 2010. 7.69 Source: Citigroup World Government Bond Indices 1-3, 3-5, and 5-7 years (hedged). The countries in the sample are Australia, Canada, Switzerland, Belgium, Germany, Spain, France, the Netherlands, the UK, Japan, Norway, New Zealand, Sweden, and the US, as data become available. The sample period is 1985 to 2010. CONCLUSION The previous examples showed the diversification benefits of moving from a US strategy to a global strategy and the tradeoffs between diversification and higher expected returns in the case in which the market coverage of the variable maturity strategy is only 50% of the global market. How do the diversification benefits and the tradeoffs between diversification and higher expected returns vary as we vary the level of market coverage? Using the same term window and assumptions as in Table 8, we repeat the exercise with different levels of market coverage, from 20% coverage, in which case the country cap for every country in the strategy would be five times their market cap, to a strategy with 100% market coverage, which is in effect the plain, market-cap-weighted strategy with all the countries shown in Table 8. Table 9 shows summary statistics for these strategies with different levels of market coverage. The monthly average return increases almost monotonically from 60 basis points per month for the market-cap-weighted index to 69 basis points to the strategy with only 20% market coverage. The return differences between the global index and the strategies with partial market coverage are all reliably different from zero, as indicated by t-statistics that are well above two in all cases, including the case in which market coverage is 90%. The monthly standard deviation increases monotonically as we move from the market-cap-weighted index to the strategy with 20% market Research demonstrates there is a reliable relationship between current observable credit/term spreads and future return differences. Wider (narrower) credit/term spreads predict larger (smaller) credit/term premiums. Market data provide the information needed to structure diversified fixed income strategies that dynamically vary the exposure to the credit and term factors, depending on whether credit and term premiums are expected to be high or low, while considering investors’ needs. If there were no relationship between spreads and returns, having a constant factor exposure would make sense. But because the relationship is strong and reliable, portfolios can use the information in current yield curves to satisfy investors’ needs without any need to forecast changes in yield curves. Investors around the world have historically had a greater home bias in their fixed income investments than in their equity investments. Investing in global bonds has important benefits that result from changes in yield curves not being perfectly correlated. First, global bonds enhance diversification in two ways: (a) They add issuers to a domestic global bond portfolio, and (b) they increase diversification by expanding the set of available yield curves. Second, a global allocation in fixed income increases the opportunities to add value by providing new term structures to expand opportunities for varying maturities. 7
  10. 10. R E S E A R C H U P D A T E 8 F O U R T H Q UA R T ER 2 011 A dynamic approach that focuses on the steepest yield curves and the steepest segments of those curves and considers the tradeoffs between increased diversification and increased expected returns is a reliable and robust way to add value in a global bond strategy. REFERENCES The helpful comments of Steve Garth, Craig Horvath, Marlena Lee, Travis Meldau, David Plecha, Eduardo Repetto, and Savina Rizova are gratefully acknowledged. 1. See, for instance, Eugene F. Fama and Kenneth R. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics 33, no. 1 (February 1993): 3–56. 2. See, for instance, Eugene F. Fama, “The Information in the Term Structure,” Journal of Financial Economics 13, no. 4 (December 1984): 509–28; Eugene F. Fama, “Term Premiums in Bond Returns,” Journal of Financial Economics 13, no. 4 (December 1984): 529–46; and Eugene F. Fama and Robert R. Bliss, “The Information in Long-Maturity Forward Rates,” American Economic Review 77, no. 4 (September 1987): 680–92. To see how this research can be applied in investment strategies, see, for instance, David A. Plecha and L. Jacobo Rodríguez, “A Market-Driven Approach to Fixed Income,” Dimensional Fund Advisors’ Quarterly Institutional Review 7, no. 1 (2011): 2–7. 3. In comparison, US equities also make up the largest share of the global equity market, about 45% of the total global equity market capitalization. 4. The countries are Australia, Canada, Switzerland, Austria, Belgium, Germany, Spain, France, Ireland, the Netherlands, Great Britain, Japan, Norway, New Zealand, Sweden, and the US. 5. These differences in returns between the US indices, on the one hand, and the global indices, on the other, are not reliably different from zero. 6. Choosing a 5–10-year term window yields similar results. The plain global strategy had a monthly average return of 66 basis points and a monthly standard deviation of 1.2% compared to a monthly average return of 73 basis points and a monthly standard deviation of 1.2% for the variable maturity global strategy. That return differential was reliably different from zero, as indicated by a t-statistic of 2.3.
  11. 11. F O U R T H Q UA R T ER 2 011 A T WHAT’S NEW AT DIMENSIONAL Zvi Bodie to Speak at Dimensional Educational Seminars Dimensional Fund Advisors is partnering with Zvi Bodie, PhD, the Norman and Adele Barron Professor of Management at Boston University and a leading expert on pension finance and investment strategy, to offer a unique educational conference series designed for plan sponsors, consultants, and advisors starting in early 2012. Zvi will present his views on plan design, next generation retirement income-oriented defaults, and investment lineups, and deliver a primer on human capital and risk. Dimensional will offer sessions on ERISA’s decision making framework, selecting and monitoring service providers, and creating a compliant policy statement. The ERISA Fiduciary Training Program, sponsored by the Plan Sponsor Council of America and approved for CFA Institute continuing education credit, will be an invaluable resource for benefits and investment professionals who design and manage defined contribution plans. Dates: March 22—Dallas July 26—Boston August 23—San Francisco November 8—New York, NY Registration details: Please check your mail in early February, contact your Dimensional regional director, or sign up online at: http://www.dfaus.com/service/dc-professionals.html N E W New Dimensional Strategies Launched Dimensional has broadened its fixed income offering for all investors with the launch of the World ex US Government Fixed Income Portfolio, which seeks to maximize total returns by investing in the investment grade debt securities of non-US government issuers and supranational organizations and their agencies. The fund, a complement to Dimensional’s Intermediate US Government Fixed Income Portfolio, expects to target a duration range around the Citigroup WGBI ex US Index (1–30+ years) and hedge its currency exposure to the US dollar. Dimensional also broadened its fixed income offering for investors in California with the launch of the California Intermediate-Term Municipal Bond Portfolio, which seeks to provide current income expected to be exempt from both federal personal income taxes and California state personal income taxes. The fund is designed to be a stand-alone solution or a complement to the California Short-Term Municipal Bond Portfolio by providing investors an option for extending their maturity exposure in California munis as well as the ability to match longer-term liabilities. Under normal circumstances, the fund will maintain a dollarweighted average portfolio maturity range of 3–10 years. D I M E N S I O N A L For more information about these or any other Dimensional strategies, please contact your regional director. New Paper Looks at Hedge Fund Fees Ronnie Shah, PhD, a senior associate in the Research group at Dimensional, authored “The Arithmetic of Hedge Fund Fees,” a new white paper that looks at the impact of hedge fund fees on investors’ returns, and compares that impact to the impact on returns of other investment vehicles. Any size and value-tilted strategy can be decomposed into a market portfolio that captures broad market exposure and a long/ short portfolio that captures size and value tilts. Whether one investment vehicle or another is better depends on the fees charged. Shah estimates that investing in a combination of market-indexed and long/short funds relative to a size and value-tilted strategy reduces net returns by 0.50% to 0.75% per year. His findings suggest the traditional 2% management fee and 20% incentive fee imposed by hedge funds cause a significant reduction in net after-fee performance. The paper is available at https://my.dimensional.com/insight/papers_library/79248/. 9
  12. 12. A P P E N D I X F O U R T H Q UA R T ER 2 011 DISCLOSURE Performance data shown represents past performance and is no guarantee of future results. Current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. To obtain performance data current to the most recent month end, visit www.dimensional.com. Average annual total returns include reinvestment of dividends and capital gains. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (310) 395-8005, or at www.dimensional.com. Dimensional funds are distributed by DFA Securities LLC. Prior to April 1, 2002, the following reimbursement fees may have been charged to purchasers of the respective portfolios: International Small Company Portfolio 0.675%; Continental Small Company Portfolio 1.00%; Japanese Small Company Portfolio 0.50%; Pacific Rim Small Company Portfolio 1.00%; International Small Cap Value Portfolio 0.675%; Emerging Markets Small Cap Portfolio 1.00%; Emerging Markets Value Portfolio 0.50%; Emerging Markets Portfolio 0.50%. Prior to April 1998, the reimbursement fees were as follows: International Small Company Portfolio 0.70%; International Small Cap Value Portfolio 0.70%. Prior to July 1995, the reimbursement fees were as follows: International Small Cap Value Portfolio 1.00%; Continental Small Company Portfolio 1.50%; Japanese Small Company Portfolio 1.00%; Asia Pacific Small Company Portfolio 1.50%; UK Small Company Portfolio 1.50%; Emerging Markets Portfolio 1.50%. Returns for these portfolios are presented net of these reimbursement fees. All reimbursement fees are based on the net asset value of the shares purchased. The standardized returns presented reflect deduction, where applicable, of the reimbursement fees for the portfolios. Non-standardized performance data reported by Dimensional Fund Advisors does not reflect deduction of the reimbursement fee. If reflected, the fee would reduce the performance quoted. Investments in foreign issuers are subject to certain considerations that are not associated with investments in US public companies. Investments of the foreign equity portfolios and the global fixed income portfolios are denominated in foreign currencies. Changes in the relative values of these foreign currencies and the US dollar, therefore, may affect the value of investments in these portfolios. However, the global fixed income portfolios may utilize forward currency contracts to minimize these changes. Further, foreign issuers are not generally subject to uniform accounting, auditing, and financial reporting standards comparable to those of US public corporations and there may be less publicly available information about such companies than comparable US companies. Also, legal, political, or diplomatic actions of foreign governments, including expropriation, confiscatory taxation, and limitations on the removal of securities, property, or other assets of the portfolios could adversely affect the value of the assets of these portfolios. 10
  13. 13. BRO-QIR

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